The Valuation Game

Between October 2016 and September 2017, the period for which the BT 500 calculations have been done, the Sensex went up by a staggering 3,040 points - a gain of 10.8 per cent. The Nifty rose 12 per cent, zooming from 8,738 to 9,788. The average market capitalisation of the combined BT 500 companies rose to `113 lakh crore, from `94 lakh crore in the year-ago period. Since October 1, the markets have risen further. On November 21, the Sensex closed at 33,478 and the Nifty at 10,326.

Ask analysts at Dalal Street whether equity markets have moved up too fast and too high and you will get contrasting answers. "We are in the middle of a multi-year bull run," says one. Another says that it is time to be a bit cautious while investing further. However, most are not willing to stick their necks out and make firm predictions.

What does the price-to-equity (PE) ratio - a barometer of how heated or depressed the market is - indicates? The BT 500 study showed that of the top 500 companies, at least 345 were trading at above their five-year median PE multiples. Does this show the market is overheated and most stocks are overvalued? Or is there still headroom for the market to rise?

It boils down to the historical metrics you are comparing it with. Jigar Shah, CEO at Maybank Kim Eng Securities India Pvt Ltd., is quick to recall the 2007/08 rally. "If this is the peak of the market, then let us look at 2007/08, as it was multiple times worse. We are nowhere near the previous peak. At present, the Nifty PE is 5 per cent higher than the long-term average, the 10-year average Nifty PE being 16.2 times." The nine year average Nifty PE between 1999 and 2008 was 17.75 Others echo the view. According to HDFC Securities, the Nifty PE multiple is currently around 25 for FY17-18 and is much lower than the peak of 28 in January 2008. Similar is the case for many of the 345 companies BT picked.

Not Overheated

Aashish Somaiyaa, MD & CEO at Motilal Oswal AMC says, "The undertone has been that of a very bullish economic forecast for the future and the markets have responded to that. But there has been some disappointment in earnings delivery." The markets have, in fact, been on a bull run - with just a few pauses - since the Modi government came to power in May 2014. Both the benchmark indices have appreciated between 35 per cent and 40 per cent.

Once in a while, there has been a fall - triggered by events such as the devaluation of the currency by China, the Reserve Bank of India's Asset Quality Review for banks, demonetisation and rollout of the Goods and Services Tax. The one point that has worried many market analysts is subdued corporate earnings. Devarsh Vakil, Head-Advisory (Private Client Group), HDFC Securities, says, "For the last four years, earnings have disappointed and grown at a CAGR of hardly 1-2 per cent. It is the expectations of future earnings which are driving the PE."

Therefore, the current Nifty PE of 25 may look high to some, but markets price in the future, and for FY19 the PE stands at 17, which according to analysts is reasonable. By the very definition, PE is price divided by earnings and markets always trot ahead, pricing in the future. Future earnings are dependent on future growth prospects and analysts are hoping that earnings, which have been stubbornly stagnant and disappointing to the superlative degree for the last three years, will now move upwards.

The market has been driven by liquidity despite the earnings disappointment. The growth rate of consensus earnings this year has been 14 per cent. Jigar points out that it is expected to be 24 per cent next year. He says, "If earnings don't catch up, we could see a 5 per cent correction." The second quarter results have been cautiously encouraging. While sales of Nifty companies grew 11 per cent, profit after tax grew 13 per cent. Growth seems to have picked up. Aashish Somaiyaa says, "We are seeing early signs of earnings revival already.

TINA effect

The 'There Is No Alternative' (TINA) effect has been driving unprecedented liquidity into the markets, both by retail investors and domestic institutional investors. No other asset class looks as attractive as equities and therefore Devarsh says that "the flow is sustainable"

Where are fund managers putting the money? Despite high PEs, fund managers of various mutual funds have a compulsion to park the money as a very limited percentage can be held in cash. But options are limited as small-caps and mid-caps have already been termed frothy; Motilal Oswal Asset Management even closed their midcap portfolio management service between January and September this year. So, where are they finding value? Well, clearly not in the high PE sectors like realty, consumer durables and FMCG. Jigar of Kim Eng Securities mentions themes like private banks, private financial companies - sectors that will be positively impacted by the government's thrust on infrastructure like the Bharatmala project and which support businesses of construction equipment, cement, logistics and power trading.

Now, if one looks at the current PE of sectors in these spaces, the power index has an earnings multiple of 20, while metals and capital goods are trading between 27 and 30, all of them offering value.

However, Aashish says that Motilal Oswal AMC is holding through some marquee private banks and putting in fresh money in insurance and oil marketing companies. Besides, white good companies are also a part of the portfolio. What looks overvalued are some NBFC stocks, he says.

Risks and worries

There are several factors that could derail this rally. The first is a fall in global markets. Jigar warns: "Globally, markets are at an all-time high and generally markets tend to mimic each other. " The second is currency turbulence. Trade deficit numbers are at a three-year high and fundamentals are not supporting the current strength. Finally, there is the spectre of oil prices rising further. It will have a cascading impact on the trade deficit and the current account deficit.

And of course, there are the results of elections in Gujarat and Himachal Pradesh. At the moment, the markets have factored in a BJP win in both, and if that doesn't happen, we could see another correction.